Stuart Brown, Swiss Re Corporate Solutions' head origination weather and energy EMEA APAC, shares his views on new risk management options available to the entire power industry thanks to wind energy production hedging.
Reporters covering financial innovation in the wind power sector have never had this much to talk about. Earlier this year, for example, the long-standing business of hedging wind producers took a big step forward when Australian producer Infigen closed the largest wind energy production hedge ever, with Swiss Re Corporate Solutions.
With plans to expand the business, Infigen's management was finding smooth relations with capital providers and lenders increasingly important. The challenge was that delivering steady cash flows is never easy in the wind business. Despite diversified energy production coming from four Australian states, the company's earnings 'followed the wind', inflicting constant cash flow uncertainty.
Meanwhile, the insurance industry has just the tools to take away that uncertainty. Wind hedgers have covered the downside of producers around the globe by using financial contracts that measure wind production and then pay for shortages as they happen. Such deals can create significant value when the assets are built or sold, as lenders provide better terms if they need not worry so much about borrowers missing debt payments when there is no wind. And when wind farms are sold, the hedge helps attract buyers who may not be wind experts but like the long-term infrastructure play of a wind producer.
So Infigen decided to lock in a level of energy production that would cover their costs and provide an investment return. It signed a wind hedge that gave it cash when wind is low in exchange for giving up some of the upside when wind is high. By 'trading the feast to pay for the famine', the company has ended up with a safer business and happier capital providers.
Of its kind
The Infigen deal with Swiss Re Corporate Solutions introduced many firsts - in referencing energy production rather than wind directly, covering a large volume over multiple locations, and paying a value per megawatt hour that covered market and green energy certificate prices. But the Infigen deal is only the beginning for a risk management industry that is innovating as fast as the wind power industry itself.
A case in point is how new approaches are changing the ways other wind risks can be managed. Wind variability is not just a risk for wind producers. Once wind power starts playing a significant role in the overall power generation system, that system has to cope with the variability of wind. Physically, electricity grid operations have proved to be very resilient in this respect - dispatch and distribution systems have learned to manage a remarkable range of unpredictability in the flow of power coming from wind energy.
However, the integration of wind power adds extensive volatility to prices for power across the affected grid. Thermal producers lose expected load when the wind comes up, and that means losing revenue. It can even mean paying to 'spill' power into the system, giving rise to the perverse but more and more frequent occurrence of negative power prices; basically, a congestion charge for using the grid.
Get a hedge
Any physical energy market that produces winners and losers contains scope for efficiency gains through trading. If a hedging instrument existed that referenced wind or wind production, then potential losers and winners could use that hedge to offset their exposure to wind in the system.
In fact, this sort of hedge is exactly what Nasdaq and EEX, the two major power exchanges in Europe, are working to create. Both have been developing futures and options products that are built around wind production indices. After two years of design, market consultation and investment, they have created indices of daily wind load in the transmission systems in Germany, the UK and Denmark. By also creating a synthetic history of what those indices would have been, the two exchanges will permit market participants to price the risk of wind production in the future. Hedgers can, in effect, take calculated bets on how much wind production there will be days and months in advance.
And when they find that their physical positions or trading positions have too much wind risk - direct or otherwise - the hedgers can manage that risk, by using these indices and the history. How? Consider a 'mid-merit' gas producer (the term simply refers to generating units that will be dispatched when demand starts to rise above baseload expectations). To plan for the next quarter, the gas producer will have a view on how much power will be sold based on a view about demand. But if there is more wind than expected, that view will not materialise and the producer will not earn as much in the quarter as planned.
The same gas producer could hedge the risk by buying a wind index option that pays out when wind is high. Wind producers will want to sell that option to hedge the risk that their sales may or may not occur. So the gas and the wind producers have a way to gain with a hedging trade that leaves both with less risk.
These examples are only the beginning of a new era in the power sector where many market players can find a benefit. Power traders can use the risk transfer products to get rid of the volatility that wind variability causes to the value of their positions. System operators meanwhile can control some of the costs associated with accommodating the shifts in supply. In short, an entire new market is being created to address the variety of exposures that wind has introduced to the power supply system.